Rather than acquire Yahoo, Microsoft should pursue SAP.

It’s not an outlandish idea. The two companies held merger talks in late 2003, and perhaps since then, too. Microsoft is in an enviable position: it is a nearly universal presence in corporate data centers, and large enterprise customers are arguably the best customers a software company can have. Clients pay very dear prices for the complex, semicustomized software that runs their business. And once they’ve got their systems running — a process that can take years to complete — they aren’t inclined to change vendors lightly.

A few dozen well-paying Fortune 500 customers may actually be more valuable than tens of millions of Web e-mail “customers” who pay nothing for the service and whose attention is not highly valued by online advertisers.

Today, SAP’s market capitalization is about $59 billion, and a sizable premium to get a deal done would send its price well north of that. Microsoft cannot put both SAP and Yahoo in its shopping cart, deals that together might run well over $120 billion. Microsoft must pick one or the other.

I’d say, with the right strategy, MSFT could have both.

Step 1: Finish off YHOO Deal

MSFT and YHOO have been playing cat and mouse for at least 3-4 years, maybe more. MSFT has never built a strong and profitable Internet business, while Google has eaten YHOO’s lunch online. This is a good deal because under Ray Ozzie’s leadership, MSFT understands it cannot win online and it cannot mess with YHOO.

Most importantly, MSFT wants to remain the most valuable technology company, and to do that, it needs a strong web and thus online advertising and search business. This is the reality that a lot of people don’t seem to want to understand: yes, MSFT ain’t no GE, but it wants to become one, rightfully or wrongfully, by getting into new businesses. We’re not arguing the merits of this strategy, we’re just stating it as fact.

In our eyes, MSFT will ultimately buy YHOO for $50B and use 2/3 cash though many YHOO shareholders would gladly take MSFT stock at these prices (regardless, using 2/3 cash would require MSFT to raise $10B in debt, a first).

Step 2: Integrate YHOO

By buying YHOO, MSFT will add $6B to its revenue base. While Google does nearly $5B in profits on $16B of revenue, YHOO did $600M. Problem is a lot of bad investing in IT and R&D.

I think MSFT + YHOO’s online ads and search revenues could easily be $8B and their profits from this unit should come in at around $2-3B. Forget the additional revenue YHOO’s 500M unique base could create for other MSFT units.

Alas, run the numbers people, and together, MSFT would be a $400B market cap company, from our earlier post:

MSFT + YHOO would command much better growth prospects than MSFT alone and as a result, the multiples would be higher, projecting a more valuable company.

In fact, by adding YHOO’s $7B revenue streams onto MSFT’s $51B 2007 revenue base, combined with YHOO’s higher P/S multiples pushing MSFT’s P/S and P/E up… MSFT being a $400B company is not out of the realm of possibility.

MSFT’s P/S is 4.52, YHOO’s is 5.81. Combined, the new company would have something near 5.25. Google’s is 9.50.

MSFT’s revenue grew from $44B in 2006 to $51B in 2007.

For 2008:

- without YHOO, just last week Microsoft raised its full-year forecasts for fiscal 2008. Revenue is now projected to be $59.9 billion to $60.5 billion, up from the Oct. 25 forecast of $58.8 billion to $59.7 billion, an increase of 1.3 percent on the high end. The average of $59.9 billion to $60.5 billion is $60.2B.

- Yahoo! alone will do $7.2B to $8B, according to their recent earnings call.

Combined this means a revenue range of $67.1B to $68.5B, or an average of $67.8B.

Using a 5.25 P/S multiple, this projects MSFT’s value to be $355.5B (low range)

That’s just using the P/S and revenues. There’s a lot of cost savings (MSFT pegs this at $1B) and the P/E projection - while less obvious - is more interesting. MSFT netted $14B in 2007. Yahoo! only $600M. Combined you are looking at a company that nets $15B in profits. Google generated $17B in revenues!

More importantly, MSFT would be able to invest all more into IT to make Yahoo! competitive. MSFT’s current P/E is 16 (but this after the week-long slide after the YHOO deal was announced), YHOO’s is 60. YHOO’s is indeed distorted due to its holdings in Alibaba and Yahoo! Japan, but there is no way that investors won’t give a combined entity firing off all cylinders in software, entertainment and online advertising anything less than 30. Google’s P/E as a pure play online advertising/search play is 38 P/E.

MSFT/YHOO profits of $15B x a P/E of 30 is $450B (high range).

Even if the P/E is a more sedate 25, then at $15B profits, you are looking at a company worth $375B.

At half of Google’s P/E, you get a multiple of 18, that yields $270B. But, that is way too low cause MSFT is right now at 16 and was above this before the YHOO was announced.

For this reason, a post-merger YHOO/MSFT would be worth near $400B (average of P/E and P/S basis) and more than offset any decline MSFT has faced this month

Step 3: Buy SAP

With a $400B market cap, swallowing SAP is much easier; oh and this assumes MSFT should buy SAP, which I doubt is really all that wise.  But assuming that is the goal:

Let’s look at SAP, currently trading at $59B market cap or $48/share.

For one, at $59M market cap, you need at least $75B to buy it, that is practically 2x what MSFT is paying for YHOO in a market that it already does well in.

More importantly, unlike YHOO that represents a once-in-a-lifetime opportunity for MSFT to acquire, SAP has actually seen its stock price go from 43.00 - 59.86 in the past 52-weeks. I do not see any urgency to make a run at SAP right now.

Moreover, with YHOO acquired and integrated and MSFT far more valuable, acquiring a company like SAP would be easier to digest for shareholders.

Bear in mind MSFT generates $1B per month in free cash flow. Even it uses the $20B it has on its balance sheet for YHOO, it will have $12B - if not more due to its organic growth rate - for more buyouts.

Conclusion:

Sorry, but if I were MSFT and long sought YHOO, there is nothing - absolutely nothing - that would make me give up my run for it. I would, if anything, accelerate the process to ensure that I could set my sights on the next big thing in order to keep Google honest.

Disclaimer: Long YHOO. Considering buying some MSFT as we speak.